Info + Advice for Indies

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Estimated Tax: Your Fair Share

How much should I pay?

You want to make sure that when you pay your fair share you do so at the last possible moment, keeping your hands on your money for as long as possible while at the same time avoiding any interest or penalty fees.

There are three approaches to paying estimated taxes. At tax filing time, you can:

Break even
or

Owe something to the government
or

Get a refund from the government.

Breaking even is smart. Owing something to the government is even smarter, if it can be done without paying interest or penalties. The third approach, paying so that you get a refund, is dumb, dumb, dumb.

Let’s look at three different ways of calculating estimated tax payments.

Not every self-employed has to make estimated tax payments.
It’s the overall tax liability of a self-employed that determines whether estimated tax payments are required. An indie’s total tax liability is made up of self-employment (SE) tax on his net self-employed earnings and income tax on all his and his spouse’s income.

SE tax and income tax on self-employed income are not the only factors in calculating estimated tax payments. If, for instance, you had a self-employed business income of $10,000 and also had investment dividends of $30,000, both these sources of income (totaling $40,000) would be factors in your estimated tax calculation. And if your wife earned $90,000 at her W-2 job, the taxes withheld from her income would also be a factor in those calculations.

Just because you are self-employed doesn’t necessarily mean that you must make estimated tax payments: For instance, if when all income and deductions are combined, there is no tax liability; or, enough tax may be withheld via a W-2 job or pension withdrawals to cover the entire tax liability; or the previous year’s tax refund may be carried forward in a sufficient amount to eliminate the need for estimated payments.

You may use one of four methods to calculate estimated tax payments.

#1. Prior Year Method

Pay this year what your tax liability was last year.
This is the easiest calculation and the safest if your income increases every year. Whatever your total tax was last year, divide that amount by four and make four payments to the United States Treasury.

High rollers beware!If your adjusted gross income (AGI) exceeds $150,000 instead of paying 100% of last year’s tax you must pay 110%. If single or married filing separately, the 110% applies to those with an AGI over $75,000. The prior year method is easy and avoids interest and penalties for self-employeds with a rising annual income.

Once again, to be clear: If you use #1. Prior Year Method, no matter how much tax you owe come April 15th you will not have to pay any penalty or interest.

#2. Current Year Method
Pay 90% of this year’s tax.
If you expect this year’s taxable income to be less than last year’s, your tax will probably be less. (I say probably because factors other than taxable income play into the calculation. Be careful.)

In this method you pay the feds 90% of this year’s tax in four equal installments.
The drawback of this method: your income projections for the remainder of the year have to be accurate. For many solo operators that’s a hard trick. If you send in less than 90% of your taxes and you owe $1,000 or more you are liable for interest and penalty.

#3. Annualization MethodYour taxable income is calculated each quarter to determine how much estimated tax to pay each quarter.

It’s like doing your tax return four times a year. This is the most complicated method and the most time-consuming. If you plan to use this method to calculate your estimated payments, discuss the procedure with your tax pro.

One Big Check On Halloween
So why would you even consider Method #3? Because in rare instances, if your income is very high or very irregular, it could work to your tax advantage. I’m talking about the computer games developer who had a really good previous year — net income of almost $300,000. Didn’t know what this year would bring. Made nothing right through the summer then on Halloween sold his patent and received a payment of $190,000. That was his only business income all year. Since he is not required to pay taxes on income before it’s received, putting off the tax payment on this income was to his advantage. He made a payment on Halloween.

#4. Government as Savings Bank Method:The dumb way.
The next time Friend Freddy tells you that Sammy Segar is a great accountant because every year he gets Freddy a big refund, ask him this: “Are you sure CPA Segar doesn’t work for Uncle Sam part-time? Why else would he set you up so that you loan your money to the IRS for a whole year — interest-free?”

How so? If you get a $1,000 refund from the government at the end of the year that means that your money was sitting in the IRS bank earning interest for Uncle Sam. If it earned 5% that’s $50 in the fed’s pocket not yours. And, to rub salt in the wound, let’s say you had a $1,000 balance on your credit card all year that you didn’t pay off because the IRS had your $1,000. At 18% that cost you $180 in finance charges. The IRS made $50 on your money, while you lost $180. So much for Sammy Segar’s big refund.

I know, lots of folks like getting a tax refund saying it’s the only way they can save money. I say, get it together and quit throwing money away. Whether through withholding or estimated taxes, if you are paying so much to the government that you get a refund, then change your ways. If you or your spouse have a W-2 job then reduce your withholding at work and have the difference automatically deposited into your own special savings account. Or, cut back on your estimated tax payment and when writing out the estimated checks to the government, write one to your savings account.

All MethodsThe smartest way to pay estimated taxes is to send the government as little as possible as late as possible, using one of the above methods.

No matter what the method, remember to look at total tax liability — not just self-employed income. And be sure to take into consideration any tax paid through withholding at a job or via other payments to you.

Be aware that if you must make estimated tax payments and you have a household employee, you must include any employment taxes for your domestic employee when figuring your estimated tax.

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